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Markets were mixed to slightly up this week; the NASDAQ, aided by strong earnings results from Netflix, recorded new highs while the Dow Jones Industrial Average declined modestly due, in part, to disappointing results from International Business Machines (IBM). Utilities stocks outperformed; the sector’s relatively high dividend yields attracted investor attention as interest rates drifted lower for the second week in a row. Oil prices were roughly flat even as the Energy Information Administration’s weekly inventory data showed continued declines in stockpiles for crude oil and gasoline. Investors are likely awaiting further evidence of an improving medium-to-longer supply outlook. Economic data point to solid growth: housing starts rose 8.3% in June; the multifamily homes segment (e.g., apartments and condominiums) gained 15.4%. And, China’s second quarter GDP rose a better-than-expected 6.9%, including an 11.0% increase in retail sales. Meanwhile, the challenges facing health care reform have left investors skeptical that Congress will enact legislation. Still, various adjustments to industry-specific regulations have helped companies reduce their costs of doing business; while these may not receive much media attention, they are nonetheless important to supporting business confidence.
Thus far, 97 companies in the S&P 500® Index have reported second quarter earnings results; of these, 71% have exceeded sales estimates and 72% have exceeded earnings estimates. For the quarter, sales are expected to rise 4.8% and earnings 7.1%. This week, results from Netflix and IBM highlighted the shift from the Old Economy to the New, and the lofty prices investors are willing to pay for the latter; Netflix currently trades at more than 100 times analysts’ earnings forecasts, whereas IBM trades at a mere 10.7 times earnings. The retail sector tells a similar story: Amazon’s price-earnings multiple of 110x dwarfs those of Kroger (11.6x) and Target (12.7x). To be sure, the variance in business models supports some of the differences; nevertheless, these are clear examples of the premiums investors are placing on companies with easily identifiable growth prospects. These companies also reflect a growing herd mentality, with investors gravitating towards stocks that have already performed well. From time to time, these trading patterns can drive up valuations for individual companies or entire industries; however, they can also reverse quickly as the herd changes direction. The crucial question is, “Can the company continue to meet such high expectations?” In contrast, value investments, which traditionally include Old Economy stocks, can provide substantial returns precisely because their already low expectations are easier to exceed.
Next week marks the peak of second quarter earnings season with 183 companies in the S&P 500® Index reporting results. A continuation of the current trend of better-than-expected results, along with supportive economic data, should help sustain the market’s positive momentum over the near-term. Longer-term, investors will begin shifting focus towards global central banks’ monetary policies and potential tax reform legislation. The backdrop of an improving global economy, though, should enable the bull market to continue.